Three bad ways to fund mortgage lending (and maybe a good way)

Any institution that wants to fund mortgages has a problem. They want to lend the money out for thirty years, but the money they have to lend comes from deposits that can be withdrawn by the depositors at any time. Banks have come up with three bad ways to work around that problem. It turns out, though, that the Danes have come up with what may be a good way.

Borrow Short, Lend Long

Since most depositors don't withdraw their deposits, bankers are always tempted to just go ahead and make mortgage loans using money from savings deposits, and then hope for the best. It's a scheme that can work, as long as nothing prompts depositors to take their money out. For more than forty years, the government supported just this scheme, by offering deposit insurance (to reduce the chance that depositors would take their money out because they lacked confidence in the banks). However, lack of confidence in banks isn't the only way the scheme can break down. It can also break down if people began to lack confidence in the money.

For almost two generations, banks routinely paid 3% on savings accounts, and then made mortgages at 6%--obviously a profitable model. Then the government let inflation get out of hand--pulling interest rates up with it.

The banks could afford to pay slightly higher prices on savings accounts--at the cost of lower profits. But once savings account interest rates approached 5%, the banks position became untenable--and if the rates had exceeded the 6% the banks were earning on their mortgages, the banks would have collapsed in short order. The banks talked the government into putting a ceiling on savings account interest to head that off, but that just prompted savers to take their money out of banks and invest it in something that paid a better return--meaning that the banks were still screwed.

The result was the S&L crisis, which ended up costing some $160 billion dollars.

So, that's a the first bad way to fund mortgages.

Floating Rate Mortgages

One solution, from the bank's point of view, is floating rates--which shifts the risk of rising interest rates to the borrower.

Unfortunately, the average mortgage borrower isn't actually in a very good position to take the risk, meaning that rising interest rates translated directly into loan defaults.

If the bank is very careful about who it lends to, it can make floating rate mortgages work pretty well, but there are only so many top-drawer credit risks in town. It's a solution, but only for a few small banks.

Securitization

The third bad way to fund mortgages--which is currently biting us as the subprime loan crisis--is securitization. Basically, the banks make mortgage loans as usual, but then sell the loan to investors.

This gets the bank completely off the hook if interest rates go up: the only money they've lent out is the handful of mortgages that they've made this month and haven't sold yet.

Unfortunately, it also gets the bank completely off the hook if the borrower doesn't pay the loan back, which produces some seriously perverse incentives for the bank--they profit on every mortgage and don't have to take any risk. (How many mortgages would you write if you got paid a few thousand dollars for every one, and were lending out other people's money?)

Things got even more complex when these mortgages were packaged up, sliced up according to risk, and sold to investors--who were relying on the value of the houses to back up the mortgages.

In the current crisis, two things went wrong. First, house values started to drop. Obviously the investors who had bought mortgages were going to be out of pocket, but the banks should have been okay. Except a second thing went wrong: It turned out that the investors who had been buying those securitized mortgages hadn't been satisfied with the small profit of holding a mortgage. In search of much higher profits, they had borrowed huge amounts of money and bought huge amounts of securitized mortgages--and they had borrowed that money from the banks. When the securitized mortgages collapsed in value, all that risk that the banks had shifted to the investors shifted right back to the banks when the investors couldn't pay back their loans.

The Danish Model

It turns out that Scandinavian countries have a funding model that may well avoid both these problems.

When a Danish bank makes a mortgage loan, it's required to sell a bond whose terms closely match those of the mortgage loan.

This protects it from the first problem, because the bank isn't at risk that changes in interest rates (or concerns about the bank's soundness) would cause depositors to demand higher rates or pull their money out. Just as if they had securitized the mortgage, they got their money back when they sold the bond.

The second problem is also avoided, because the mortgage is at a fixed rate.

Finally, the third problem is avoided, because the homeowner still owes his mortgage to the bank. That means that the bank has the appropriate incentives to lend to people who will be able to pay the money back.

As a bonus, the bond that matches the mortgage trades on the financial markets, just like any other bond. If something (such as a rise in interest rates, or a fall in home values) makes these bonds lose value, homeowners can actually buy a (now cheaper) bond that matches their home mortgage--and then turn it in to the bank in fulfillment of their mortgage. (It ought to be possible to do roughly the same thing by renegotiating the mortgage, but banks resist doing so unless they're forced to. This mechanism makes it work automatically, without the bank needing to be cooperative--or coerced.)

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1) IPO - Newly launch listed companies use this way to get more funds to purchase land/building using investors money. It is cheap and no need to repay.

2) They issue rights, which force their existing investors to put in more money or sell it to others who in turn put in more money into the company. It is cheap, but will devalue a share price, which I think doesn't matter in the long run.

I do like the fact that mortgagee's can buy the bonds at discount values and pay off their loan faster. It promotes liquidity in the market and allows people to exit bad positions in the bond market.

One thing this type of instrument does not solve is systematic risk. Risk still exists in the system but the risk has been offloaded somewhere else. I'm quite sure there is a property bubble in Denmark (like the rest of the world). When the hammer falls it just hits where the most risk was taken.

If I'm reading correctly the Denmark model does leave much of the risk in the bank's hands. If the borrower defaults then the bank still has to pay the coupons. If too many people default then the bonds become impaired and the bank will be under severe stress. In that scenario this would lead to failure of the bank. Bank run? Bailout? In any event the result would be the same as the US banking crisis.

The banking system can be made more resilient by requiring much higher capital ratios. That means much more money needs to be set aside for eventual losses when the business cycle turns. The generation of bankers after Great depression bank had a reputation of keeping their reserves high. However decades of complacency has lead to lower and lower reserves. There is also the fact that locking money in reserves guarantees banks profits cannot be maximized (who wants smaller bonuses??).

Banks are now belatedly trying to increase reserves via capital raisings. All rather too late. Perversely the governments around the world are trying to coerce banks to lend again when they are trying to be more prudent!

In the end the only long term solution to this problem is to allow banks to go bankrupt. The Great depression generation's reputation for prudence wasn't born, it was made via harsh experience. If you get burnt badly it is unlikely you will make the same mistake for a very long time.